The Peril of Anointing a Favored Financial Few

We, the people of the United States, uphold equal protection of the law. Equality was first claimed to be a God-given right in the Declaration of Independence. Its practical manifestation took several amendments to the Constitution, significant legislation, and two centuries of struggle. Even today, this equality is not always satisfied in practice, but it should always and everywhere be a national aspiration.

Except, apparently, in the finance industry.

The Obama administration’s proposed financial industry reform would institutionalize a two-tier system of banking. Big, well-connected, and complicated firms would receive the special protection of being designated too big to fail. They would operate under their own rules, enforced by their own financial stability cop. In return, they would be held to higher capital and leverage standards, evidently the purchase price of this special status.

The White House proposal misdiagnoses the problem, fails to recognize the inherent adverse dynamics of regulation, and treats the bulk of the industry unfairly.

In fact, the package hits the trifecta of bad policy making. The White House proposal misdiagnoses the problem, fails to recognize the inherent adverse dynamics of regulation, and treats the bulk of the industry unfairly.

Our fundamental problem is not that institutions deemed too big to fail do not get sufficient scrutiny. Our problem is that some institutions are deemed too big to fail. This designation confers advantages to those institutions: lower funding costs and better access to credit.

The lesson taken away by managers of financial institutions is to get big and complicated so that regulators will fear financial interconnections too much to trust market forces at a time of stress. This complexity makes it impossible to understand the risk profile of a large institution from the outside. Thus, effective supervision is a nonstarter and market discipline is blunted.

The complexity also makes it unlikely that there can ever be a reliable resolution mechanism that regulators would be willing to employ when the going gets tough. Even worse, the resultant complexity lessens managers’ ability to understand risk-taking within their own firms. Weak internal oversight opens up the opportunity for abuses that create crises when employees look to their own short-term interest and not the longer-term needs of their firms and their customers.

The administration has the touching faith that additional regulation can correct these inherent flaws. But that neglects that we are here precisely because regulation and supervision failed to govern complicated structures properly.

Our fundamental problem is not that institutions deemed too big to fail do not get sufficient scrutiny. Our problem is that some institutions are deemed too big to fail.

Moreover, we have no reason to expect that regulators will get better over time. Regulation is decidedly pro-cyclical—it gets tough when markets are volatile and intolerant toward risk and easy during booms. Legislation might get the right treatment of capital and leverage at the outset. Over time, as markets tolerate more risk and the past year recedes into memory, the small cadre of the favored big guys will almost certainly lean on the financial stability regulator for more lenient treatment. This inner circle will also concoct new balance-sheet structures to stay one step ahead of bureaucrats.

Also note that officials have been extremely reluctant to define the perimeter of too-big-to-fail protection. One thing we know is that the perimeter will never shrink, and at times it will grow. After all, Bear Stearns was a moderate-sized investment bank that would be under the radar of too-big-to-fail protection in normal times. When markets were volatile, the Federal Reserve was willing to break a 60-year-old precedent and lend to the nonbank institution to facilitate its takeover.

Lastly, in anointing a favored few, the administration would hardwire unequal treatment for the rest of the industry. The next time markets get skittish, creditors and investors will flee to big firms, recognizing that the U.S. government stands behind them. Thus, small- and medium-sized firms, the engine of innovation, will face an uphill struggle. And the patent unfairness of the system will ultimately undercut the support of the public, already made suspicious by the revolving door connecting the executive suites of our government and the too-big-to-fail firms.

FURTHER READING: Reinhart wrote “The High Cost of Getting the Story Wrong,” describing how the narrative first written about the Great Depression was mistaken in many important respects, as is the initial narrative on today’s crisis. His other pieces for The American include “Simple Rules for a Complex Financial World” and “When They Were Young,” a look back to the last time that Larry Summers, director of the National Economic Council, and Timothy Geithner, secretary of the Treasury, “saved the world.”